On the positive side of the ledger, net book growth in the Life Business was strong at 7.9%, before the AMP and Japanese distribution relationships fully kicked in and before the BT relationship planned for June this year has started. The Funds Management business was strong across the board.
On the negative side of the ledger, headline product margins declined, although 85% of the decline was explained by product mix changes and therefore not particularly meaningful as all products generate similar returns on capital. A key area of focus was the capital position, and in particular the increased capital intensity of the Life Business during the half. This is understandable as Challenger raised $500m in equity in August with the placement to its Japanese distribution partner MS&AD, meaning many would have expected Challenger to have some capital “runway”.
In financial services, there are a wide number of ratios that are analysed to death. In simple terms, Challenger ratios were distorted by the impact of the capital raising and the associated lags in putting this capital to work. Judging by the number of questions on this topic at the result presentations, this surprised the analyst community. This is surprising as we have seen similar distortions to these ratios when capital has been raised in the past, and is common sense that capital raised during the period cannot be fully deployed.
As a case in point, Challenger invested the money raised from the placement into listed investments to reach its target asset allocation. These types of investments carry the highest capital charge. However, once annuities are written against this capital it will be redeployed to match the duration of the annuities written and this will reduce capital intensity.
What is the market missing?
Challenger has always been a stock in respect of which, over the short term, the market can often not see the forest for the trees.
We think Challenger is one of the best exposures to the rapidly growing Australian retirement market, where annuities are becoming a far more common solution being demanded by retirees.
Challenger is for all intents and purposes ‘the market’, and it has demonstrated its ability to generate attractive returns. As opposed to most other players on the retirement market, Challenger revenues are not directly sourced from the Government and therefore carry less regulatory risk.
While in the context of other financial services products annuities are capital intensive, Challenger has options to fund this requirement with the equity market showing repeatedly that it is prepared to back the business.
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Shane has over 22 years of financial services experience working for JP Morgan, UBS and Monash. His role includes research, analysis, dealing and investment management of the Monash Absolute Investment Fund. He is also co-founder of Monash Investors.